Tuesday, March 17, 2009

Mark-to-market vs cost accounting

I'll quote Buffett here: "It's better to be approximately right than precisely wrong."

Mark-to-market accounting makes VERY large assumptions about market efficiency that just aren't true. At times, large groups of people act irrationally in the exact same way, and for a time, things can get priced far below or above their intrinsic worth.

The problem is that when you mandate mark-to-market accounting (basically, something is listed as valued at what the market will currently pay for it, instead of what you paid for it originally, or what an educated guess is of what you're likely to recover for it in the end), that creates a positive feedback loop that amplifies the effect - so even if original mispricedness was irrational, it can wreck lending.

I understand the problems with letting banks model out what they think their securities will be worth and valuing them that way - there's an incentive to inflate the number. However, the swings of market panic are often much worse than a consistent inflation of value - if something is always 30% inflated, movements in the price of that security are amplified by only 30% in dollar magnitude (and 0% in percentage). Unfortunately, mark-to-market significantly increases swings in market value, and that's a problem when market value determines actionable ability.

To pose the question a different way... do you really think no mortgages will ever be paid off? Because a lot of assets are almost priced that way.